Page 611 - Accounting Principles (A Business Perspective)

15. Long-term financing: Bonds

employment for approximately 10 per cent of the city's population. The city had benefited from the
revenues the company attracted to the area and from the generous gifts provided by the father.
The remainder of the common stock was widely held and was traded in the over-the-counter
market. No other stockholder held more than 4 per cent of the stock. The stock had recently traded
at USD 30 per share. The company has USD 10 million of 10 per cent bonds outstanding, which

mature in 15 years.
The brothers enjoyed the money they received from the company, but did not enjoy the work. They
also were frustrated by the fact that they did not own a controlling interest (more than 50 per cent)
of the company. If they had a controlling interest, they could make important decisions without
obtaining the agreement of the other stockholders.
With the assistance of a New York City brokerage house, the brothers decided to pursue a plan that
could increase their wealth. The company would offer to buy back shares of common stock at USD

40 per share. These shares would then be canceled, and the Rawlings brothers would have a
controlling interest. The stock buy-back would be financed by issuing 10-year, 14 per cent, high-
interest junk bonds. The brokerage house had located some financial institutions willing to buy the
bonds. The interest payments on the junk bonds would be USD 3 million per year. The brothers
thought the company could make these payments unless the country entered a recession. If need
be, wage increases could be severely restricted or eliminated and the company's pension plan could
be terminated. If the junk bonds could be paid at maturity, the brothers would own a controlling
interest in what could be an extremely valuable company. If the interest payments could not be met
or if the junk bonds were defaulted at maturity, the company could eventually be forced to

liquidate. The risks are high, but so are the potential rewards. If another buyer entered the picture
at this point and bid an even higher amount for the stock, the brothers could sell their shares and
exit the company. Two of the brothers hoped that another buyer might bid as much as USD 50 per
share so they could sell their shares and pursue other interests. The changes a new buyer might
make are unpredictable at this point.

The times interest earned ratios in a recent year for several companies (described in footnotes to the table) were
as follows:
Earnings before Interest Times Interest
Interest and Expense Earned
Company Taxes (millions) (Millions) Ratio
Ford Mother Company a $19,136 $10,902 1.76
Proctor & Gamble Company b 6,258 722 8.67
AMR Corporation c 1,754 467 3.76
Dell Computer Corporation d 3,241 47 68.96
Hewlett-Packard Company e 4,882 257 19.00
A Ford Motor Company is the world's largest producer of trucks and the second largest producer of cars and trucks combined.
B Proctor and Gamble markets more than 300 brands to nearly five billion customers in over 140 countries.
c AMR's principal subsidiary is America Airlines.
d Dell is the world's largest direct computer systems company.
e Hewlett-Packard Company designs, manufactures, and services products and systems for measurement, computation, and communications.
You can see from these data that a great deal of variability exists in the times interest earned ratios for real
companies. To judge the ability of companies to pay bond interest when due, bondholders would carefully examine
other financial data as well.

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